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Commentary

Tomorrow’s generation will foot the bill

By
Jagadeesh Gokhale

This article originally appeared in the Financial Times on February 13, 2004.

The latest US budget numbers indicate that the deficit for 2004 will exceed $500bn (€390bn), an increase of almost $150bn over 2003. This cloudy fiscal outlook prompted Alan Greenspan, chairman of the Federal Reserve, to issue a strong cautionary message this week: “The imbalance in the federal budgetary situation, unless addressed soon, will pose serious longer-term fiscal difficulties. One critical element — present in the 1990s but now absent — is a framework of procedural rules to help fiscal policy makers make the difficult decisions that are required to forge a better fiscal balance.”

Mr Greenspan’s remarks hint at the need to reintroduce federal spending and financing constraints, similar to those included in the Budget Enforcement Act of the 1990s.

The BEA was allowed to lapse when projections began to show federal surpluses. This may have been prompted by any of several sensible reasons: to avoid federal purchases of private assets; to help an economy in recession; to return taxpayer funds, and so on.

This suggests that such budget constraints alone may not be sufficient to encourage the higher saving, investment and output growth needed to prepare for the coming wave of baby-boomer retirements. A new Budget Enforcement Act would, again, be abandoned as soon as big federal surpluses re-emerged — and for good reasons. The problem is that, in the absence of constraints, the remaining budget institutions are inadequate to prevent current generations from socking it to future ones: witness the post-BEA enactment of a massive and unfunded Medicare prescription drug benefit for America’s senior citizens.

Existing institutions fail to arbitrate a resource-allocation “dispute” between living and future generations, both of which have “claims” on present and future national output. While successful economies have effective systems to adjudicate property conflicts among the living, fairly arbitrating one between living and future generations is difficult, because the unborn cannot stand up for their claims. This leaves current generations free to vote large and unfunded public benefits for themselves and to bequeath massive public debts to future ones. Under current budget accounting in America, most such debt remains hidden. Less appreciated by current generations is that if they grant themselves too much by way of unfunded benefits today, they could end up winning a battle but losing a (generational) war.

The expected impact of today’s policies on tomorrow’s outcomes will influence today’s private economic choices — especially choices made by today’s younger generations and succeeding generations as they grow up. For exam ple, current policy decisions may imply that taxes on labour or capital will be much higher in future. In anticipation of much higher labour taxes, younger generations may choose to invest less in acquiring productive skills — because the higher salaries they would win as a result would be taxed away. Higher labour taxes might also discourage skilled immigrants. Both reactions would amplify the “sucking sound” of jobs being shipped abroad. When jobs go overseas, capital is unlikely to be far behind. In addition, the prospect of higher taxes on income from capital — and therefore lower investment returns — could make it difficult for the US to attract the level of foreign capital that supports domestic investment.

These tendencies will reduce employment and productivity, and shrink the national output available for today’s voting generations when they retire. So when today’s voters promote ever larger unfunded benefits for themselves, they may be increasing their share of overall output, but they are also reducing the pool from which it will be drawn.

Of course, one could argue that living generations’ fear of losing the generational war will check their fiscal profligacy.

But, unlike the war that some observers predict — in which the younger generation votes to cut benefits, while the older lobbies to raise taxes — this one will be fought covertly. It will involve younger generations making private choices in response to profligate increases in unfunded benefits by older ones. To avert the consequences of such actions, younger generations, and their successors, will have to be encouraged to behave in ways that promote growth.

Because greater government saving is undesirable, the only remaining avenue for increasing saving and investment appears to be a private, and necessarily decentralised, system of retirement saving: an “individual accounts” reform of Social Security would be a good start.

A similar reform of Medicare appears even more imperative, given its much larger fiscal imbalance — $40,000bn including prescription drugs. Such reforms could limit the ability of today’s electorate to vote itself unfunded benefits.

President George W. Bush’s call for this type of Social Security reform in his 2004 State of the Union speech points in the right direction. The chances are, however, that such institutions will develop only if budget accounting reforms are passed to reveal the full extent of the debt being bequeathed to future generations.